Founders in start-ups often believe that they can be paid in stock or equity instead of cash. They’re putting the hustle in now, and they’ll get the pay off later—when that equity is worth serious money. From the outside this looks like a win for both parties: the company gets to save real money now in exchange for theoretical money later.
In fact, for a lot of founders and companies this isn’t even a real question. The purpose of this post is to explain that it really, really, really should be.
To answer that theoretical question we need to look to at least two governing bodies: the federal government through the Fair Labor Standards Act (“FLSA”) and the state of incorporation/operation.*
The FLSA provides basic, nationwide standards on rules like the minimum wage and overtime policies. The FLSA also provides exceptions under exemptions for certain categories of employees. One of the exemptions—the key one here—is referred to as the “Executive Business Owner” exemption (specific text here, broader context here). Under the Executive Business Owner exemption, an individual doesn’t need to be paid the minimum wage, or in fact, any wage at all if:
a) They’re employed in a “bona fide executive” capacity;*
b) They’re actively engaged in the management of the business; and
c) They own at least a 20% interest in the business.
So that 1.75% minority owner that you’ve got happily coding up your product? She can’t be paid in equity, she needs to be paid in actual United States Dollars. That’s a matter of federal law, and there’s no (legal) way around it.
But wait, there’s more!
As stated above, the FLSA provides the minimum standard, and it’s not the only governing body with a say. In this arena each state has its own rules, and a lot are stricter than the federal government; the minimum wage in Washington, DC, for example, is almost is double the federal standard. Most importantly for our current discussion, some states don’t have this Executive Business Owner exception. That means that in certain states even majority founders need to be paid the minimum wage, regardless of whether they own 25%.
What can happen if you don’t pay the minimum wage? I can’t predict the future, but here are two concerns a reasonable entrepreneur should have:
a) The Founder that didn’t get paid leaves the company, for whatever reason, on somewhat bad terms (the “Departed Founder”). The Departed Founder somehow finds out about this law, because lawyers, and the Departed Lawyer makes a complaint with either the state or federal government, whichever one will get him more money. Said government sees a pretty open and shut case, and makes the company pay back-pay, possibly including overtime, plus some potentially heart-stopping penalties, like 3x the amount owed. Oh and the other side’s attorneys fees get thrown in too. The rest of the Founders and employees find out and now the company owes everyone money, with said penalties in tact.
b) You make it big, are at a really nice point in the M&A transaction, and the other team’s lawyers find out about this liability in due diligence. Because lawyers. The investors decide they don’t want to invest in a series of back-pay awards and lawsuits, and there goes the deal.
What’s the TL;DR?
Don’t assume that founders or employees can be paid in equity instead of cash. Do a deep dive into relevant state laws, and confirm the scenario. And maybe, just maybe, hire a lawyer to confirm for you, so that you don’t need to hire a more expensive lawyer to defend the lawsuit(s).
*Sometimes because of state laws, the place the employee performs their work, or the state where they live matter just as much as where the company is located.
**For those seeking specifics, a bona fide executive is someone that
a) Makes at least $684 a week (as of 1/1/20),
b) Whose primary duty is management of the company or one of its subdivisions, and
c) Who has the authority to hire or fire employees, or whose suggestions on hiring, firing, and promotion have serious weight.
Full concept here